Signs of the Times

Some quotations from June are worth repeating - perhaps for some they may
be worth regretting.

"Freddie Mac says the subprime mess is contained."

"Fund manager says, 'The whole subprime mess has been basically
looked over and is not taken as a big concern'."

- Bloomberg, June 26

"Bernanke said [mortgage-backed securities] are
a valuable market innovation and 'sometimes there are bumps' in
the new-product road."

- Market Watch , July 19

The first new era of financial innovation ran until the South Sea
collapse of 1720. A dismayed, and possibly damaged observer complained:

"the English Nation run a madding after new inventions, whims,
and projects [promotions], that impoverish, fiddle
them out of their money, by the strange, un-heard-of engines of
discount, transfers, tallies, debentures, shares, projects, and
the devil and all figures and hard names."

"U.S. stocks retreat on subprime concerns; American Home plummets [On
the day, down 90%]."

- Bloomberg, July 31

"The latest red flag: American Home Mortgage Investment -
which doesn't specialize in subprime lending - said it is suffering
steep margin calls from its own lenders."

- Wall Street Journal, August 1

Everyone knows that the Chairman has to say comforting words
with the early signs of distress. There is no way of knowing his private
thoughts, but as someone fully qualified in interventionist theories it is
likely that he is sincere in his statements.

As for the above quotations from "Freddie" and the fund manager, they represent
blatant cheerleading, with hopes of protecting their book.

It is important to discredit (scary connotation) the very popular notion
that it was "liquidity" that was driving the markets and prosperity. Actually,
as history so frequently shows, the mechanism works the other way - soaring
prices stimulate leverage, which is a practical but impolite word for credit
expansion. Then when collateral prices turn down it initiates the credit
contraction.

As that occurs the powers of the margin clerk (or mortgage officer) overwhelm
the powers of the central banks to inflate credit or, as real bankers used
to say, "create money out of thin air".

Stock Markets: Our theme since earlier in the year has been that the
yield curve was usually helpful in determining a cyclical peak in the stock
markets. Typically the ultimate thrust runs for some 12 to 16 months against
an inverted yield curve.

Inversion began in February 2006, which counts out to somewhere close to the
second quarter of this year, when a spectacular surge could conclude the bull
market. The further refinement was that, while inversion could indicate inevitability
of a top, it was when the curve reversed to steepening that - as we phrased
it - the wheels begin to come off the most intense speculations.

Such reversal became apparent in late May, and accomplished by mid June.

Obviously the wheels have been coming off. A number of speculations, such
as nickel plunged 41% from the May high and the subprime crisis resumed in
mid May, which hit traditional corporate spreads in late June.

History's point has been that a credit expansion will eventually culminate
in reckless lending and borrowing. Speculation in price will eventually exhaust
itself and the price decline will relentlessly force the credit contraction.

This began to be proved, once again, as the turn down in house prices prompted
the subprime "mess" which is inducing liquidity concerns in other sectors.

Lacking a comprehensive appraisal of its own limitations, the world of policymaking
is confident that financial problems can be contained.

Essentially policy making is reliant upon faulty logic and faulty research.
The notion that the Fed can keep a recovery going by expanding credit is based
upon the observation that business expansions are accompanied by credit expansions.
This is correct, but the assumption that credit expansion will force a business
expansion is not.

Indeed, in logic it is a glaring example of a primitive syllogism that assumes
that because two things occur at the same time they are causally related. The
old example is a rooster crowing causes the sun to rise.

Faulty research by most of the establishment fosters the notion that the Fed
will lower interest rates and as an institutional analyst wrote last week, "But
let's be clear - the Fed is likely to cut rates - and that should spark a stampede
of new buying."

As popular as that thinking is, it is not supported by empirical evidence.
Throughout the past 300 years, short-dated market rates of interest increase
with a business boom and decline with the contraction. In so many words, so
long as short rates are rising the party is on, and this is good. Declining
rates typically indicate that the part is over and this is bad.

Three-month treasury bills set their high in late February and, although modest,
the decline has been associated with some rather bad stuff.

At the moment the stock market is oversold enough to prompt a sharp rally.

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